Chap 11 Study Notes

I. Introduction1. The corporation is the only form of business recognized as a separate legal entity.2. Creation and governance of corporations are highly regulated by law.3. Corporations are created under state (not federal) laws. Each state has different laws for

incorporation. Benefits of Stock Ownership

1. The ownership of common stock conveys several rights:a. A voice in management: Owners are granted the right to vote at stockholders' meetings on

major issues concerning the management of the corporation including the election of the board of directors. In lieu of attending a meeting, a vote by proxy (absentee ballot) gives the stockholders’ voting rights to a designated party.

b. Dividends: Owners may receive dividends (distributions of corporate profits).c. Residual claim: Owners may receive distributions from the corporation upon liquidation.

II. Authorized, Issued, and Outstanding Shares1. Authorized number of shares is the maximum number of shares that can be issued by a

corporation as specified in its charter. This should be a larger number than a corporation plans to issue initially to provide for future flexibility.

2. Issued number of shares is the total cumulative number of authorized shares that have been issued to date by the corporation. Unissued number of shares is the number of authorized shares that have not yet been issued to date.

3. Outstanding number of shares is the number of shares currently owned by stockholders ("out" there).

Outstanding # shares = Issued # shares – Treasury Shares

4. Treasury stock is the number of shares that have been issued to investors and then reacquired by the corporation. If there is no treasury stock, the number of issued shares will equal the number of outstanding shares.

III. THE EARNINGS PER SHARE RATIO.

1. EPS is a measure of profitability.2. Facilitates comparing companies of different sizes.

IV. THE CHARACTERISTICS OF COMMON STOCK AND ANALYZE TRANSACTIONS AFFECTING COMMON STOCK.

A. General1. There are two types of stock issues. 2. All corporations must issue common stock, but preferred stock is not issued by every

corporation.

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B. Common Stock Transactions1. Common stock is the residual equity (the "leftovers") of a corporation.

a. It ranks after preferred stock for dividends and liquidation distributions. b. Common stockholders are the "risk takers" and, therefore, they are voting owners of a

corporation.2. Common stockholders receive dividends after the preferred stockholders receive their

dividends. Dividend rates are determined by the board of directors, usually based on the company's profitability for common stockholders.

3. Two types of common shares may be issued by a corporation: par value and no-par value.a. Par value is a nominal (arbitrary) value established in the corporate charter.

1. It has no relationship to the market value of the stock. 2. The initial issue of stock may be at par value or at a premium (above par value). 3. In most instances, the initial issue of stock may not be at a discount (below par value). 4. The concept of par value was established as a protection for creditors by specifying a

permanent amount of capital (legal capital) to be maintained by the corporation (not available for withdrawal by the owners). Though the definition of legal capital varies among states, it is usually considered to be the par value of stock outstanding.

b. No-par value stock does not have an amount per share specified in the charter. 1. Some states require no-par stock. 2. Legal capital is established by law. In the case of no-par value stock, legal capital is

either the amount for which stock is originally sold or a stated value.C. Initial Sale of Stock

1. When a corporation sells stock to the public, the transaction must be recorded in the accounts of the corporation. When stock sales are made for cash, Cash is debited and Common Stock is credited for par value.

Cash xxxCommon Stock xxx

2. Any additional amount in excess of par is credited to Capital in Excess of Par Value ( or APIC, additional Paid In Capital)

Cash xxxCommon Stock xxxCapital in Excess of Par Value xxx

3. In the case of no-par common stock that has no stated value, the total proceeds received at the issue are debited to Cash and credited to No-Par Common Stock. The capital in excess of par value account is not used under these circumstances.

4. There are two types of initial stock offerings to the public.a. An initial public offering (IPO) involves the very first sale of a company's stock to the

public (when a company first goes public).b. A seasoned new issue is a subsequent sale of new stock (not previously issued) to the

public after an IPO.

D. Sale of Stock in Secondary Markets1. After the issue of stock by a corporation, shares may be exchanged (traded) in secondary

markets such as the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and the NASDAQ market.

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2. These subsequent sales only affect the books of the investors involved. a. No transactions are recorded on the corporation's books. b. However, corporate management is very alert to stock trading prices in the secondary

market.

E. Stock Issued for Employee Compensation1. Executive compensation packages are often developed to reward managers for meeting goals

that are important to shareholders. a. Stock options are often part of these compensation packages. b. Stock options permit the holders to buy stock at a fixed price (grant price).

1. If the stock prices declines below the grant price, holders will not exercise the option. 2. If the stock price increases over the grant price, holders can exercise the options at a

“low” price and hold the stock or sell it for a gain.c. Stock option plans have increased substantially over the past few years. These plans

provide a very popular way to reward managers.

F. Repurchase of Stock1. Treasury stock is previously issued stock that is reacquired by the issuing corporation.

a. Held by the corporation.b. Has no ownership rights. c. It is not outstanding stock so it has no right to vote or to receive dividends. d. It is not an asset to the corporation. e. Treasury stock is a contra equity account (it reduces total stockholders' equity).

2. The cost method records treasury stock at its cost:

Treasury Stock xxxCash xxx

a. This transaction reduces assets and reduces stockholders’ equity.3. Balance Sheet effects:

a. If a company has treasury stock on its balance sheet date, the amount of treasury stock is subtracted in the stockholders' equity section.

b. Note disclosure is required. c. A restriction is placed on retained earnings to the extent of the treasury stock cost to

preclude dividend declarations of that amount.4. Resale of Treasury Stock

a. When treasury stock shares are resold, Cash is debited and treasury stock is credited (reduced by the cost of the proportional number of shares resold).

b. If treasury stock is acquired and resold for the same amount, that is the extent of the journal entry.

c. If the acquisition and resale amounts differ, additional elements appear in the journal entry.1. Treasury stock is resold for more than its cost (an economic gain):

a. Capital in Excess of Par is credited for the difference. b. Results in an overall increase in stockholders' equity.

2. Treasury stock is resold for less than its cost (an economic loss):a. Capital in Excess of Par is debited for the difference. b. If that account balance is not adequate to absorb this difference, Retained

Earnings is reduced to the extent needed. c. Results in an overall decrease in stockholders' equity.

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5. Neither the purchase nor the sale of treasury stock affects the issued or unissued number of shares. Treasury stock only affects the number of shares outstanding.

V. DIVIDENDS AND ANALYZE TRANSACTIONS.

A. Investors buy stock to receive a return on their investment in the form of stock price appreciation and/or dividends.1. Dividends are created when the board of directors of a corporation declares them. There is no

legal obligation of a corporation to pay dividends until they are declared.2. Types of dividends:

a. Cash dividends. (Without a qualifier, the term dividend means a “cash” dividend.)b. Property dividends (noncash assets).c. Stock dividends (the company's own capital stock).

B. There are two requirements to be met for cash dividends to be declared and paid.1. Sufficient retained earnings is needed. State laws often limit cash dividends to the amount of

retained earnings (less any amount of treasury stock).2. Sufficient cash is needed.

a. Retained earnings does not equal cash. b. Cash is needed for continuing operations and for operational asset acquisitions. There must

be adequate cash after these commitments are met in order to pay dividends.

C. Three important dates for dividends:1. Date of declaration:

a. The date that the board of directors officially approves the dividend. b. For a cash dividend, a liability is credited at that time (Dividends Payable).c. The debit may be made to a Dividends Declared account or directly to the Retained

Earnings account. d. Dividends Declared is a contra equity account that is closed to Retained Earnings.

2. Date of record:a. The date on which the corporation prepares a list of current stockholders based on

stockholder ownership records. This list indicates to whom dividend checks will be sent.b. No journal entry is required on this date.

3. Date of payment:a. The date that dividend checks are disbursed. b. The liability account is debited (reduced), and the Cash account is credited (reduced).c. This is the date on which the dividend liability is liquidated.

VI. THE DIVIDEND YIELD RATIO.

1. A measure of profitability.2. Measures the dividend return on the current price of stock.3. Must be considered in conjunction with stability and growth of the price of common stock.

VII. THE PURPOSE OF STOCK DIVIDENDS, STOCK SPLITS, AND REPORT TRANSACTIONS.

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A. Stock Dividends1. A stock dividend is a distribution of additional shares of a corporation's own capital stock on

a prorata basis (to maintain the same percentage of shares previously held) to its stockholders at no cost. a. Usually consist of common stock issued to holders of common stock. b. Common for rapidly growing companies that want to retain their assets to finance growth.

2. Balance Sheet effects:a. Does not create a liability when it is declared.b. Does not reduce assets when it is distributed. c. Total stockholders' equity does not change.

1. A portion of retained earnings is changed into contributed capital. This is called capitalizing earnings.

2. When retained earnings is reclassified to contributed capital, it reduces the amount available for future dividends.

3. Stock dividends are classified based on their size. The size of the stock dividend dictates the accounting treatment.a. A large stock dividend involves the distribution of additional shares that is more than 20-

25% of the currently outstanding shares.1. Par value is used to record large stock dividends.2. Retained Earnings is debited and common stock is credited for the par value.3. Large stock dividends have a greater market price reaction than small stock dividends.

b. A small stock dividend involves the distribution of additional shares that is less than 20-25% of the currently outstanding shares.1. Market value is used to record small stock dividends.2. Retained Earnings is debited for the market value of the shares, common stock is

credited for the par value, and the difference is credited to Capital in Excess of Par Value.

B. Stock Splits1. Stock splits are not dividends, but stock splits and stock dividends have similar effects on the

stockholder. a. Each stockholder will own additional shares of stock. b. The effects on the issuing company are quite different.

2. A stock split does not require a journal entry by the corporation.a. Instead, the old shares are returned to the corporation and new shares are issued.b. The stock split is accomplished by reducing the par value per share and increasing the

number of shares issued. c. Retained Earnings is unaffected.d. Note disclosure is required for stock splits.

VIII. THE CHARACTERISTICS OF PREFERRED STOCK AND ANALYZE TRANSACTIONS AFFECTING PREFERRED STOCK.

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A. Preferred Stock1. Combines some of the features of bonds and common stock.

a. Typically lacks the control feature of common stock in that it usually does not have voting rights.

b. Often used to raise corporate capital without diluting common stockholders' control.2. Generally, preferred stock is less risky than common stock because of its preference to receive

dividends and asset distributions (upon liquidation) before common stockholders.3. Most preferred stock has a fixed dividend rate such as a specified percent of par or a specified

amount per share. (Dividend/year = Dividend rate * Par vale)

B. Dividends on Preferred Stock1. Investors in preferred stock give up some rights (voting) compared to common stock. 2. Preferred Stock enjoys a preference in dividends.3. Dividends must be allocated between preferred shareholders and common shareholders. Two

dividend preferences are:a. Current Dividend Preference

1. Preferred stock always has a right to be paid dividends before any dividends can be paid on common stock.

2. Once this current preference is met, dividends may be paid to common stock.b. Cumulative Dividend Preference

3. Some preferred stock carries the additional feature of accumulating any current dividend amounts not declared in a previous year.

4. Dividends In Arrears are these "unsatisfied" accumulations. 5. Stock with this feature is called Cumulative Preferred Stock.

IX. THE IMPACT OF CAPITAL STOCK TRANSACTIONS ON CASH FLOWS.

Effect on Cash Flows from Financing Activities

Issuance of Capital Stock IncreasePurchase of Treasury Stock DecreaseSale of Treasury Stock IncreasePayment of Cash Dividends Decrease

Practice Questions:

1.The charter of Delta Corporation specified a maximum of 25,000 shares of common stock. At the current date, 5,000 shares remain unissued, and 2,000 of the issued shares have been reacquired

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and are still held by Delta. Give the number of shares:

Type Sharesa. Issuedb. Unissuedc. Authorizedd. Outstandinge. Treasury stock

Answer:Type Shares

a. Issued 25,000 – 5,000 = 20,000b. Unissued 5,000c. Authorized 25,000d. Outstanding 20,000 – 2,000 = 18,000e. Treasury stock 2,000

2. The balance sheet at December 31, 2006, showed the following data for ASC Corporation:

Common stock, par $1 (authorized 150,000 shares) 100,000Treasury stock (at cost $10 per share) 2,000

Give the number of shares for each item.

Type Sharesa. Issuedb. Treasuryc. Unissuedd. Authorizede. Outstanding

Answer:

Type Sharesa. Issued 100,000 1 = 100,000b. Unissued 150,000 – 100,000 = 50,000c. Authorized 150,000 givend. Outstanding 100,000 – 200 = 99,800e. Treasury stock 2,000 10 = 200

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3. These three dates are described below. Assume a $25,000 cash dividend.

Part A: Name the dates in the space provided.

Description Name of the Datea. Date on which the Board of Directors votes on the

dividend.b. Date on which the names are taken from the

stockholder records.c. Date on which the dividend checks are mailed.

Part B: Prepare the journal entry for each date.

DescriptionJournal Entry

a. Date on which the Board of Directors votes on the dividend.

b. Date on which the names are taken from the stockholder records.

c. Date on which the dividend checks are mailed.

Answer:Part A: Name the dates in the space provided.

Description Name of the Datea. Date on which the Board of Directors votes on the

dividend.Declaration date

b. Date on which the names are taken from the stockholder records.

Date of record

c. Date on which the dividend checks are mailed. Date of payment

Part B: Prepare the journal entry for each date.

DescriptionJournal Entry

a. Date on which the Board of Directors votes on the dividend.

Dividends declared (or retained earnings) Dividends payable

25,00025,000

b. Date on which the names are taken from the stockholder records.

No entry

c. Date on which the dividend checks are mailed.

Dividends payable Cash

25,00025,000

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4. Contrast the economic effects of a cash dividend (declared and paid) with a stock dividend (declared and issued) on the distributing corporation by completing the following chart by placing “X” where appropriate.

Economic Effect

Cash DividendStock Dividend

Item on Financial Statement Increase Decrease Increase DecreaseAssetsLiabilitiesCapital stock issuedRetained earningsTotal stockholders’ equity

Answer:

Economic Effect

Cash DividendStock Dividend

Item on Financial Statement Increase Decrease Increase DecreaseAssets

XLiabilitiesCapital stock issued XRetained earnings X XTotal stockholders’ equity X

5. HighRise Company reported the following amounts of contributed capital in the stockholders' equity accounts as of January 1, 2010:

Contributed Capital: Common stock, par $5, authorized 50,000 shares; Issued and outstanding 30,000 shares $150,000 Contributed capital in excess of par 100,000

Accounts

A. Cash F. Treasury stockB. Dividends payable G. Contributed capital-Treasury stock

transactionsC. Common stock H. Dividends declaredD. Contributed capital in excess of par I. None of the above accounts (specify)

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E. Retained earnings

Indicate the journal entry required to record each of the following transactions by entering the letter code corresponding to each account to be debited and credited and the amount of each debit and credit. The transactions are independent unless otherwise stated.

Transaction Debits CreditsCode Amount Code Amount

Ex. Sold and issued 10 common shares at par. Disregard in subsequent transaction.

A50 C 50

1. Dec. 1, 2010—The board of directors declared a $2 per share cash dividend payment which will be paid in 2011.

2. Dec. 1, 2010—The board of directors declared (and issued) a 10% stock dividend. At the date of declaration market price per share was $11.

3. Dec. 2, 2010—The corporation sold and issued 20,000 shares of its common stock and received $10 cash per share.

4. Dec. 28, 2010—The corporation purchased 200 of its own shares at $10 per share.

Answer:Transaction Debits Credits

Code Amount Code Amount

1. Dec. 1, 2010—The board of directors declared a $2 per share cash dividend payment which will be paid in 2011.

E or H $60,000 B $60,000

2. Dec. 1, 2010—The board of directors declared (and issued) a 10% stock dividend. At the date of declaration market price per share was $11.

E or H 33,000CD

15,000 18,000

3. Dec. 2, 2010—The corporation sold and issued 20,000 shares of its common stock and received $10 cash per share.

A 200,000 CD

100,000100,000

4. Dec. 28, 2010—The corporation purchased 200 of its own shares at $10 per share.

F 2,000 A 2,000

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6. On January 1, 2008, the stockholders' equity section of Gibbons Corporation's balance sheet showed the following

Common stock, par $10, authorized 100,000 shares,

outstanding 10,000 shares$100,000

Contributed capital in excess of par 50,000

Retained earnings 160,000

During the year, 2008, the accounts showed the following summarized transactions (assume they occurred in the order given):

(1) Issued a 10% stock dividend; 1,000 shares issued when the market price was $12.

(2) Purchased treasury stock (200 shares at $11).

(3) Declared and paid a cash dividend of $19,800.

(4) Net income, $30,000.

The stockholders’ equity section of the balance sheet at December 31, 2008, should report the following:

GIBBONS CORPORATION

STOCKHOLDERS’ EQUITY

Common stock, par $_____; authorized _______ shares; issued _________ shares; outstanding _____ shares. $_________

________________________________________________________ __________ Total _________________________________________________ __________

________________________________________________________ __________ Total _________________________________________________ __________

________________________________________________________ __________ Total stockholders’ equity $_________

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Answer:

Stockholders’ Equity

Common stock, par $10; authorized 100,000 shares; 11,000 issued; outstanding 10,800 shares $110,000

Contributed capital in excess of par 52,000

Total contributed capital 162,000 Retained earnings 158,200 * Total Contributed capital and retained earnings 320,200 Less: Treasury stock, 200 shares (at cost) (2,200 ) Total stockholders’ equity $318,000

*160,000 - $19,800 – (1,000 shares x $12) + $30,000 = $158,200

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